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Islamic Finance in Practice

Islamic finance primarily means any establishment of financial resources which is being governed by the Sharia law (Ben Naceur, Barajas and Massara, 2015). As regards the nature and methods of financing, in principle, any financing technique respecting the prohibition of interest and speculation is acceptable. These rules lay the foundation for the Islamic financial system, with the alternative being crowdfunding based on profit sharing and risk of loss.

We observe, however, that Muslim economists, lawyers and financiers, after a century of breaking away from their legal heritage, have had to face the need to devise Islamic alternatives to interest-rate financing. Islamic banks and Islamic subsidiaries of traditional banks have thus designed legal and financial mechanisms which are based on concepts called mudaraba, mousharaka, mourabaha, ijara ...

Financing “with participation”

The first type of financing is based on the principle of profit and loss sharing. In one case, the bank is content to provide finance capital to the entrepreneur.

This is referred to as a moudaraba, a passive partnership contract akin to the operation of a limited partnership in our traditional financial system. Indeed, the bank (the donor partner) does not have any say in the management of the project. In the event of failure, the capital loss is fully borne by the bank (Munawar and Moyneux, 2005).

Conversely, in the case of a Mousharika, the bank can intervene in the management of the project. By virtue of its operating methods, this active partnership between the entrepreneur and the bank is similar to a joint venture commonly encountered in traditional finance. In the event of failure, the loss is borne by all the partners (at least two) according to the capital contribution previously made by each (DiVanna, 2006).

Financing “without participation”

"Non-participating" transactions mainly concern transactions of a commercial nature (purchase or sale of assets). Murabaha and ijara are the most widely used contracts.

The first is a sales contract subject to specific clauses resulting from the principles set out in Sharia law. The sale must be instantaneous, the item sold lawful and its price clearly displayed and justified. This type of contract can also be used as a source of financing. In this case, the Islamic bank acts as a financial intermediary between the buyer and the seller. In effect, the bank buys a good in cash on behalf of a customer and then resells it at a price plus a profit margin.

The ijara is like a conventional finance lease or rental agreement. Unlike the murabaha, this type of contract transfers the usufruct of the property, that is to say the right to use it, and not its entire property (Dar and Azami, 2012).

The legitimacy of the prohibition of interest

The failures of the classic financial system

The legalization of the interest rate is considered a major success achieved by the liberal current. However, Islamic civilization condemns lending at interest. According to Joseph Schacht, in his Encyclopedia of Islam, usury is, "in general, any illegitimate precarious advantage without equivalent of the service rendered". Already, the prophet Mohammad condemned the interest at low rate as well as that at high rate: “From Anas Ibn Malik: the prophet said: “when someone from you grants a loan and the borrower offers him a dish, he must not accept it; if the borrower offers him a ride on an animal, he should not accept it, unless the two were in the habit of exchanging such favors mutually” (Bari and Radi, 2011). Unlike other schools of thought, Islam does not distinguish interest from usury, these two operations are reprehensible. Islam is neither the only one nor the first to condemn the loan at interest, other monotheistic religions (Jewish and Christian) and other schools of thought have done it before: Aristotle (-384 - -322) for example qualifies the practice of lending at interest as detestable, because it consists in creating money from itself, when money was created for exchange, not to serve itself (Čihák and Hesse, 2010).

One might think that this debate on lending at interest is exceeded in the economies of the xxistcentury, which is not the case, since there are regulations on interest rates in several “emergent” economies around the world. Contrary to the idea supported by Islamic finance, which fixes the interest rate at 0% and which does not differentiate between low rates (interest loan) and high rates (usury), Western economies tolerate low rates, prohibit and sanction the practice of high rates. Several criteria can justify this regulation. Prohibition therefore persists in our contemporary economies under different names and with, on the one hand, reasons similar to those invoked by morality, such as "the protection of the weaker party", and on the other hand more rational reasons, like economic efficiency (Hesse, Jobst and Sole, 2008).

According to papers by Sidney Homer and Richard Eugene Sylla (2001), throughout history the norm has been to regulate the interest rate. These practices are more commonly known as usury laws, (Jobst, 2007) and they have always aroused the indignation of economists who see them as an obstacle to the spontaneity of transactions (Jobst, 2007).

From a technical point of view, setting an interest rate hinders the free functioning of the capital market and over determines investment decisions in all funding markets. From a competitive point of view, the usurious system catalyzes the accumulation of capital and the creation of monopolies skewing competition and entrepreneurial initiative (Chapra and Umer, 2008). According to various researches (), the classic financial system has the following effects:

• Inhibition of the investment decision: the interest rate, as a reference for all other usurious transactions, inhibits investment because the internal rate of return of projects must necessarily be higher than the interest rate to hope to be profitable;
• Allocation of capital to the least risky or best-guaranteed debtors;
• Short-term investment strategy: in the climate of financial preference for the present and of repression of the risk resulting from the usurious practice, short-term investments with high profitability and little risk are preferred to investments with better economic rationality, strategic and environmental;
• Inequitable distribution of profits;
• Debt problem: the refusal to share the risk on the part of the creditor introduces a debt trap mechanism that leaves little chance of exit to the debtor. This phenomenon can also be observed in the international indebtedness of the poorest countries;
• The problem of prudential rules: the usurious banking system, characterized by the authorization given to private banks to create money through the fractional reserve system, makes the prudential control of their banking activities problematic (Basel I 1988 and Basel II 1998), because only the criterion of profitability constitutes the main motivation of the business world (example of Enron and Anderson 2003).
• Reduction of the national level of the investment ratio due to the selection of projects: the interest rate creates a ratchet effect exerting an inverse selection on any investment project whose internal rate of return is lower than the interest rate. As a result, a barrier to entry into the credit market is artificially maintained, with the consequence of reducing the national level of investment;
• The rigidity of the price level: by setting ex-ante a rate of remuneration for the loan of money, the entire elementary price adjustment mechanism according to supply and demand is biased;
• Debt problem: indebtedness becomes a brake on economic growth at national and international levels. It blocks the normal life of business and creates risks of insolvency;
• Monopoly concentration of capital;
• Systemic instability problem;
• Accumulation of capital and deactivation of market equilibrium;
• Financial instability and chronic crises;
• Mobility of financial assets against the natural rigidity of the production tool (stateless capital);
• Increase in unemployment.

 

Islamic Finance and Ethics

Islamic finance advocates ethical finance and is built upon eight strong pillars. First, the invested money must always be collateral with a tangible asset; in addition, the religion Islam tends to encourage economic activity; however, it considers that the production of goods and services, investments and trade should take place within the framework of the real economy, which creates effective value. Money cannot create money, it is the contribution of human effort which consecrates the creation of the value made possible by money (Sole, 2007).

Secondly, all contracts needs to be concluded over the ideologies of balance and fairness. A contract relating to an investment must call for the equitable or just sharing of the profits, losses and risks that it may entail. In Muslim law, contracts by which one of the parties would unfairly exploit his co-contracting party or perceive a gain to his detriment are deemed null. A Muslim can only make profits from any trading activity or transactions that are conducted on a transparent basis of risk sharing. For instance, it is strictly forbidden to make a financial profit such as a late payment penalty on a debtor in default of payment.

Third, contracts must ensure that the elements of uncertainty are removed, and contract loyalty is built by eradicating uncertainty as comprehensively as possible. Any contract whose underlying object is uncertainty is deemed to be null (Tahir and Haron, 2010).

Fourth (this is the most well-known point, but they are all equally important), money is seen as a mere medium of exchange and money uncorrelated as a contribution. Human effort is not measured to have the capability of creating value, hence the illegality of the interest amount paid over the provision of a sum of money. The objectivity of this prohibition is based on several moral considerations, including the following two: (1) the unfair and discriminatory nature which makes it difficult, if not impossible, for gaining access to credit for those who are the most disadvantaged, (2) the rate of interest generates an uncertain or unequal distribution as to the risks taken, the profits made and the failures suffered, whether for the investors’ benefit, as such remuneration could exempt the person from the consequences of the failure, mainly because the rate of interest can be a form of remuneration without risk, or that it is for the benefit of the entrepreneur who would be likely to capture most of the profit in the event of success. Such a position confirms this concern for a fair balance between the contribution of money and the contribution to industry to make the creation of effective value (Abedifar, Molyneux and Tarazi, 2013).

Fifth, a sharing obligation must apply to the gains made. Islamic finance practices sharing finance, which consists of reserving part of the profits for non-governmental organizations, humanitarian organizations or simply the poor. Believers fulfill this moral obligation by donating part of the profits made through zakat; this obligation can be compared to the wealth tax, but the base and the base are different. There is also another way to pay zakat. Islam recognizes the part of imperfection which can attach by their nature to certain human projects and ensures that this inevitable character of imperfection is compensated by devices of purification on inevitable activities, whereas they are illicit. Ethical compliance must be verified and monitored (Beck, Demirgüç-Kunt and Merrouche, 2013).

Difference between Islamic Banking and Conventional Banking Model

The portfolio model of traditional or conventional banks as well as Islamic banks, it can be seen that Islamic banks tends to invest in more resources than that of traditional banks within economic as well as commercial transactions. Now, these banks are channeling a lot of resources in the procurement of different treasury bills as well as other government bonds which tend to produce a higher rate of return, pose little risk, and carry significant tax benefits.

It is noted that within Muslim countries, businesses have greatly reduced their dependence upon conventional banks by investing and trading through Murabaha operations and substituting them for costly credit lines which is allowed to finance their funds. The aspects of Ijara or leasing functions which are being offered by Islamic banks now allow businesses to fund their operations.

Within the orthodox banking system, the bank’s role is to obtain funds from external sources and advance those as lending activities, generally long-term, i.e. to function as a financial intermediation. The bank derives its income by working with credit and debit interest rates. Contrasting to this, Islamic banking is not engaged in making industrial, commercial or agricultural-based transactions (Ayub, 2007).

Interest is strictly prohibited in Islamic banking. This collects funds from savers like the traditional bank, which will be used in different operations. However, these operations are based upon the principle of participation or that of the Sharing of Profits and Losses. From the philosophical point of view, customers can make great partners.

If they are remunerated “depositors”, should provide consent towards risk sharing of the activities that are financed with these deposits. In case they are “borrowers”, the banking institution will advance funds to them and is hence a partner within such activities.

When an Islamic bank, gets involves within a procedure of resource allocation (deposits of customers), it will act as a trustee of depositors as well as principal vis-à-vis active capitalists to whom the funds are advances necessary for start-up. of a project (Moucharaka). It therefore has a double contractual relationship. Important implications arise from this double contractual relationship. Despite the resulting conflicts of interest, the bank is the big winner (Hijazi and Hanif, 2010).

In fact, depositors, while presuming all of the risks, will pay management charges to that of the bank. There will be no guarantee over the fixed amount over their deposits as a traditional bank might do, but assumes to pay a certain share of the profit generated or, in case of failing this, to debit them with a share of the losses incurred, if applicable.

In addition, the depositors will not benefit from any insurance that is placed against, their deposits and do not have any direct control rights over the choice of investment that is made on part of the bank. At the same time, Industrialists, who are also partners and agents, will also get a share in the profits, according to a percentage. In case if that project tends to suffer from losses, only the banker and the depositors assume them. As for the entrepreneur, his risk is limited to wasting his time and effort (Zaman, 2010).

In the agency relationship which needs to be developing amongst the bank as well as its agent, the choice of the entrepreneur is therefore critical. For assuring a certain control over the activities of the project, the bank which is also a shareholder that is insisting over having a seat amongst the board of directors along with imposing certain accounting ratios in terms of the management, if required. This condition is all the more difficult or even normally unacceptable for depositors since the financial institution might not have real power of governance over the managers that are willing to move one step further itself of the companies in which it invests.

These investors were not the shareholders and hence, hold no rights to vote. Financing through Islamic bank is the regulatory shareholder of investment companies and funds. It is the financial institution which, with the help of these funds, holds the right for overseeing firms within which these mutual funds are invested. The investors or depositors do not have control over it (Thorsten, 2007).

Islamic banking sector, not being lenders within the classic sense of the word, enforces any way in the aspect of disciplining corporate executives playing a role of the creditor like that of a commercial bank. This needs to be intervened, for example, when the signs of being defaulted over a loan starts to appear. On their part, Islamic banks can intervene only as a shareholder through their presence on the board of directors

Debt forces executives to act in a manner more consistent with the interests of shareholders. This diagram assumes of course that the directors do not hold any shares.

In an Islamic context, however, certain refinements apply.

·         Financial markets operating within Islamic nations are not that much developed in comparison to markets operating through for corporate control.

·         Debt financing is strictly forbidden, since all forms of financing should be on part of equity or in other words like leasing or Mudaraba. 

However, it can be seen in a circumstance in which the classic pattern of transforming deposits in that of loans might be losing its ground, these Islamic banks tend to hold a head start over the conventional banking technique in Muslim nations with respect to "security" as well as same products to the investors (depositors).

The lead of Islamic banking is that in addition to the religious psychological satisfaction that customers derive from them, the profits being distributed by the Islamic banks are always at least equal to the interest received by depositors from conventional banks for similar amounts (Choong and Ming-Hua, 2006).

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