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Islamic finance: how to earn money without interest?

The second installment of the Global finance webseries on Islamic finance.

Many of the products offered by Islamic financial institutions are comparable to Western or conventional finance even though interest and speculation are prohibited. Banks are by far the main players in Islamic finance – some of them are exclusively Islamic while others offer Sharia-compliant products but remain mostly conventional.

Besides the absence of interest rates, the key concept of Islamic finance is the sharing of risks between the parties in all operations. Here are some of the main Sharia-compliant products that banks offer – they have Arabic names, but in most cases we can find an equivalent in conventional Western banks.

Murabaha or sale price plus: this is the most common product in asset portfolios and only applies to the purchase of commodities. Instead of taking a loan at interest to buy something, the customer asks the bank to buy an item and sell it for a higher price in installments. The bank’s profit is determined in advance and the sale price cannot be increased once the contract is signed. In the event of delay or default in payment, different options are available, including a third party guarantee, collateral guarantees on the client’s property or a penalty to be paid to an Islamic charity as it cannot go into the income of the client. the bank.

Ijara or leasing: instead of giving a loan to a customer to buy a product like a car, the bank buys the product and then leases it to the customer. The client acquires the property at the end of the rental contract.

Mudarabah or profit sharing: Investment in which the bank contributes 100% of the capital intended for the creation of a business. The bank owns the business entity and the client provides management and manpower. They then share the profits according to a pre-established ratio which is generally close to 50/50. In the event of business failure, the bank bears all financial losses unless it is proven that it is the customer’s fault.

Moucharaka or joint venture: An investment involving two or more partners in which each partner contributes capital and management in exchange for a proportional share of the profits.

Takaful or insurance: Sharia-compliant insurance companies offer products comparable to conventional insurance companies and operate like a mutual fund. Instead of paying bonuses, participants pool the money and agree to redistribute it to members in need according to pre-arranged contracts. The mutual fund is managed by a fund manager.

The fund can be managed in different ways with regard to the distribution of surpluses and the remuneration of the fund manager.

There are three main models:

  • The wakala – when the fund manager receives a commission and the excess remains the property of the participants.
  • The mudarabah – adapted from the banking system where profits and losses are shared between the fund manager and the participants.
  • The hybrid model – A mixture of mudarabah and walkala.

In some cases, the fund manager creates a waqf, or a charity fund.

Soukouk or bonds: Sharia-compliant bonds began to be issued in the 2000s and standardized by AAOIF—a Bahrain-based institution that has been promoting Sharia-compliant regulation since 2003. Today, more than 20 countries use this instrument. Malaysia is the largest emitter, followed by Saudi Arabia, and issuers outside the Muslim world include the UK, Hong Kong and Luxembourg.

The sukuk show took off in 2006 when the show hit $ 20 billion. Aside from a decline in 2015-16, volumes subsequently increased steadily to a record high of $ 162 billion in 2019, up 25% from 2018. This record number was supported by a strong appetite from Malaysia , Indonesia, the Gulf Cooperation Council (GCC). country and Turkey.

This was before COVID 19. According to the Standard & Poor (S&P) rating agency, the volume of issuance is expected to drop by around $ 100 billion.

“The market was, in fact, poised for good performance in 2020, but the pandemic and falling oil prices have changed the outlook. Under more difficult conditions, we also do not see the main Islamic finance countries using the sukuk as their main source of financing despite their higher financing needs, ”S&P says in its 2020 report. report on Islamic finance.

Other industry experts disagree. Refinitiv research indicates that sukuk issuance will continue to grow and could reach $ 174 billion in 2020, supported by government funding requirements.

Like conventional bonds, sukuks are very attractive to governments because they raise funds to be spent on development projects. Their main challenge remains standardization; buyers tend to find it more difficult to assess risk than with regular bonds.

Islamic finance also exists in the form of investment funds.