Common Questions About Islamic Finance (Part 5 of 5)

This week…
— I don’t have enough money to buy factory equipment (or a car, a home or pay for an education)? How do I avoid interest and still fulfill my short-term financing requirements?
— Is there a secondary market for Islamic instruments?

Previous weeks…
— There was no Islamic bank during the Prophet’s (Allah bless him and give him peace) time, so how can there be Islamic banking now? Sounds like a bid’a. (Click here to view)
— Don’t Islamic banks simply change labels, by replacing the word “interest” with “profit”? (Click here to view)
— Why does Islam forbid interest when money is just another commodity that comes at a price? (Click here to view)
— Where should I keep my money? Islamic banking doesn’t adequately address the inflation problem and you say interest banking is forbidden. (Click here to view)
— Stocks are like gambling, but Islam permits stocks and forbids gambling. Why? (Click here to view)
— What’s the difference between an ordinary lease and an Islamic lease (ijarah)? They look the same. (Click here to view)
— If Islam forbids fixed-income interest, what’s wrong with floating-rate interest? Doesn’t it also rise and fall like profit? (Click here to view)

I don’t have enough money to buy factory equipment (or a car, a home or pay for an education)? How do I avoid interest and still fulfill my short-term financing requirements?

Murabaha (mark-up financing) is an example of an Islamic instrument that funds short-term capital requirements. Because it is the most easily confused with interest-based financing, it is worthwhile going through the basic steps in a murabaha execution: A customer approaches an Islamic bank with a request to purchase an item, promising to pay at some later date. The bank assesses the product and the customer’s collateral (collateral is an Islamically acceptable method of securing a financial obligation) and agrees by making the customer its agent. The customer goes to the market and selects the product. The bank pays the vendor, charges the customer a mark-up, and the customer takes the product agreeing to pay later.

This is analogous to a friend buying something on your behalf, charging a little extra for the time and effort, and selling it to you with an expectation that you will repay him at some later date. This is instead of giving you cash to buy it now, and asking for the cash at some later date, charging you interest in addition to the loan amount.

In a murabaha, the bank provides financial intermediation entirely free of interest, and because the bank buys and sells an asset, even if at a profit, the transaction is Islamically permissible. The difficulty people have in differentiating a murabaha from a simple short-term loan is by not appreciating the importance of the seemingly insignificant intermediate step of the bank owning the item by paying the vendor directly. What this does is satisfy the very basic Islamic requirement of backing the transaction with an asset. The mark-up is no different from the profit any business makes for having provided a legitimate service.

For home purchases, diminishing partnership schemes (or “diminishing musharakas”) also provide the buyer with a financing alternative. In a diminishing partnership arrangement the buyer approaches the bank with a down payment. The bank pays for the rest of the property and the buyer begins living in the property while paying the bank rent. Over time, the buyer buys back the bank’s equity in the house and reduces his monthly rent in proportion to his increased ownership of the house. Eventually, the buyer becomes the sole owner. The important point is that the Islamic bank participates in the customer’s ownership risk.

Is there a secondary market for Islamic instruments?

A secondary market is a fancy name for any exchange where securities (like stocks) are bought and sold after their original issuance. Islamic leases, or ijarahs, are an example of a securitizable instrument.

Because lessors have the right to sell all or part of their leases to one or more third parties without affecting the continuity of the lease itself, ijarah certificates may be traded like securities under certain conditions. An ijarah certificate represents the third party’s new ownership in the lease as well as the proportionate share in claiming rent and suffering loss. Ownership, not the right to claim rent, represents the tradable portion of the certificate. Islam permits the trading of assets, not of money, for profit, and a rental claim is a receivable that represents money. So trading rental claims without first transferring ownership is forbidden. But it is acceptable for buyers seeking ownership and sellers seeking profit to trade ijarah certificates like common securities in a capital market.

Islamic banks face an unusual set of competing demands today. On the one hand, the Islamic banking sector is growing at about four times the rate of the industry as a whole. But on the other hand, Islamic banks are forced to conform to a regulatory environment that has traditionally catered to a well-entrenched interest banking system. As a result, Islamic banks now inherit a customer base so accustomed to dealing in interest that to suggest an alternative, particularly one with a well-laden “Islamic” label attached, is to imagine the seemingly unimaginable. But in just the first few decades of consumer-level Islamic banking, a centuries-old conventional finance sector is beginning to acknowledge the importance of providing an Islamic alternative, evidenced most tellingly by the creation of Islamic subsidiaries within conventional Western banks. And because all banks, whether Islamic or not, are profit-motivated and demand-driven, it is important that the Islamic banking customer demands products that are compliant, for which the first step is self-education about what actually makes a financial product Islamic.

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