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24.11.2006

A useful guide to islamic banking

Islamic banking is based on islamic law, which is also called Sharia. Sharia law derives from the Qur'an (the holy scripture of the islamic world) and the Sunnah (description of the words and deeds of the Prophet Muhammad). As the Qur'an does not support the division of religion and state, every economic transaction has a moral dimension and should be beneficial to society.

A central piece of islamic banking is the prohibition of interest (Riba) which is clearly defined as sinful in the Qur'an. Interest transactions are considered unproper (haram). Financial transactions where only one party carries the risk (e.g. certain derivative instruments) are equally prohibited. This also entails a prohibition of instruments with a certain 'gambling' character, such as options, futures, hedge funds, day trading and short positions. This might come as a blessing for some investors, as the exclusion of the latter instruments makes islamic banking less risk sensitive.

Equity financing, however, is permitted (halal) but one should be careful about choosing the right company. Tobacco firms, entertainment industry or corporations from the conventional finance sector are definitely on the black list. But that's not all. A 'compliant' firm has to abide to some financing rules. Bond capital of halal firms may not surpass one third of its market capitalisation. Additionally, some cash flow figures must be in certain limits, as hoarding of money is also considered haram. Six percent of the benefits must be given to charity.

Although the rules (and prohibitions) are numerous, islamic finance covers a vast product palette:

Equity financing (Mudarabah) is the alternative for a traditional credit transaction. The bank is the lender of capital and receives a contractual participation in project revenues. If the bank also provides some management services, this financing is consired as Musharakah.

Halal corporations can borrow capital in the form of islamic bonds (Sukuk). Instead of interest bond holders receive some participations rights in real estate leasing revenues (Ijarah).

Islamic investment funds: the Dow Jones Islamic Market (DJIM), which covers 1993 international 'halal' companies, is the the benchmark for sharia-compliant investments. These funds are offered by islamic but also by a growing number of Western banks.

Islamic insurance (Takaful): A certain amount is deducted from the insurance premium and given to charity. The Takaful market is the smallest segment of islamic finance with a current volume of only five billion US-Dollars. However this segment is growing faster than others with a growth rate of 25 percent per year.

Derivatives: are forbidden in islamic finance, but it is possible to buy basket certificates of halal shares.

Source: Schweizer Bank


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