Islamic finance has become increasingly significant since the mid-1970s and has made its presence felt, both in the eastern and western worlds. The growth in national and personal wealth in the Middle East over the past 25 years has coincided with a resurgence in the influence of Islamic beliefs in various parts of the world. This has created a strong demand for a financial system which enables Muslims to make use of their wealth in a manner consistent with their beliefs.

Market dynamism has been felt in both the traditional Islamic finance centres and a number of other markets.

Sukuk – the Islamic finance world’s equivalent of a traditional bond – has taken the Islamic finance industry by storm over the recent years, with most of the origination in Malaysia and the Gulf Co-operation Council countries.

Although Sri Lanka is yet to witness any sukuk issuances, there is a growing interest in these instruments to tap the liquidity of the Muslim community in Sri Lanka. Presently, Islamic institutions and community have limited investment vehicles that are in accordance with Islamic principles. This together with the tight liquidity in the conventional finance market has fuelled interest in Islamic Finance. However, in order to support the growth of this alternative instrument, regulatory, accounting, legal and tax issues need to be resolved.

In Malaysia’s case, the Islamic finance market has grown from strength to strength and is one of the fastest-growing capital pools, rapidly being drawn into the mainstream financial system. The Malaysian Sukuk market, in particular, has successfully evolved out of its infancy. The viability of Islamic finance is no longer an issue; the success of the domestic Islamic bond market - within a relatively short period - is a firm testament to investors’ widespread acceptance of Islamic financing principles in that country.

Principles of Islamic Finance

The cornerstone of Islamic finance is that funding is not provided for monetary returns. Rather, Islamic finance is based on contracts of exchange. Under such contracts, assets or services will be exchanged for money, or for other assets. These give rise to sale and purchase contracts or leasing contracts. 

Among the fundamental components of Islamic finance is the Shariah board. Shariah simply refers to Islamic law and Shariah boards are councils that are made up of Islamic scholars who ensure that all the activities of a company are in accordance with Shariah. Although Shariah interpretations may vary from one board to another, the differences are very minimal. The challenges can be mitigated by creating an apex Shariah council so that there is uniform practice in the industry. In Malaysia, Islamic securities are based on principles and concepts that are approved by the Securities Commission of Malaysia’s Shariah Advisory Council.

Types of Islamic Contracts

The foregoing are structures that have been observed in the Malaysian context. RAM Ratings Lanka notes that these are not prescriptive structures as each market will have its own preference with regard to the underlying Islamic structure; over time, these can and do change.

Murabahah

A contract referring to the sale and purchase transaction for the financing of an asset, whereby the cost and profit margin (mark-up) are made known and agreed upon by all parties involved. The settlement for the purchase can either be on a deferred lump-sum basis or via installments; this is specified in the agreement. Murabahah is the most popular and most common mode of Islamic financing. It is also known as mark-up or cost-plus financing. The word Murabahah is derived from the Arabic word Ribh, which means profit. Murabahah is a contract of sale in which a commodity is sold for profit. In this case, the seller is obliged to tell the buyer his cost price and the profit he is making.

There are a number of requirements for this transaction to be a real transaction, in order to meet the Islamic standards of a legal sale. The entire Murabahah transaction must be completed in 2 stages. In the first stage, the client requests the bank to undertake a Murabahah transaction and promises to buy the commodity specified by him, if the bank acquires the same commodity. Of course, the promise is not legally binding. As the client may renege on his promise, the bank risks the loss of the amount it has spent. In the second stage, the client purchases the item acquired by the bank on a deferred-payments basis, and agrees to a payment schedule. Another important requirement for a Murabahah sale is that the 2 sale contracts, one through which the bank acquires the commodity and the other through which it sells the same to the client, should be separate and real transactions.  

Bai Bithaman Ajil A contract that refers to the sale and purchase transaction for the financing of an asset on a deferred basis. The buyer may be allowed to pay by installments within a pre-agreed period, or in a lump sum. The sale price includes a profit margin.

 Although this principle had been popular in the past, it is now not as widely used for Islamic securities in Malaysia given the lack of acceptance by Islamic jurists in other parts of the world. 

In the next article, we will be discussing other types of Islamic contracts, namely Istisna, Ijarah, Mudharabah and Musharakah.