Islamic Financing Techniques

Here are few of the commonly used investment techniques of leading Islamic banks.
1. Mudaraba: It is a partnership agreement where one partner provides the funds while the other manages it.
2. Musharaka: It is similar to the previous technique with the only difference being that the managing partner also provides with a part of the capital required. Hence there is a greater incentive to investing wisely.
3. Murabaha: Here the bank buys out the inventory/goods/assets and then later on resells it back to the firm at a pre-defined mark-up. Although the mark-up is very similar to the interest rate payable to conventional instruments, the bank bears the risk of obsolesce of the goods/services.
4. Ijara: This is a leasing agreement where the bank buys the assets and leases it back to its clients.
5. Salam: It is a forward buying agreement used for agricultural produce.
6. Istisna: It is used to finance construction or commission manufacturing projects. Here one party buys the goods and other party undertakes to manufacture them.


Fundamental Principle of Islamic Finance

The most interesting aspect is that almost all major religions in the world are against charging interest. Christianity and Judaism explicitly prohibit charging interest. Hinduism text is full of references of how evil it is. Till 12th century all across Europe charging interest was banned. Medici family of Italy exploited a loophole in the Bible to create one of the first modern banks (that charged interest) and soon afterward the entire world forgot how evil interests are. The Islamic banking seems to be the people in the world who still haven’t forgotten their religion.

In Islam all assets (money, land, property etc.) are considered a gift of god and so is the time. So interest (riba) is viewed as making profit solely due to passage of time by exploiting the plight of those in need by those in excess. A man should not be able to make money from the mere fact that he/she has and others don’t. This is against the fundamental principle of social, economic and political fairness and hence is against Islam.

To confirm with the Islamic principles of finance, one has to abide by Sharia. However it is an abstract form of law capable of adaptation, development and interpretation. The most acceptable form of Sharia used by the financial world today has evolved from the interpretation of the text of Quran, Sunna, ijma and ijtihad/qiyas by the 4 independent schools Hanafi, Maliki, Shafi and Hanbali. However because of the minor differences in opinions and thoughts most Islamic banks consult from time to time a religious committee of religious scholars which supervise their investment activities and make amends.

Following 3 principles are common between the 4 main schools:
1. Riba/Interest: Under Islam interest is banned. Instead it is replaced by a profit and loss sharing agreement. So in essence there is no guaranteed rate of return and the banker has to share the risk. So in essence a lender of capital should not make money which is calculated on the basis of how long the money was borrowed but on the basis of how useful the money was for the borrower.

2. Gharrar/Gambling: One should not bet on chance, uncertainty or speculation.

3. One should not invest in ventures that can destroy the humanity eg: alcohol.

Note: I am neither a Muslim nor an expert in the ways of Islam. Hence please correct me if you believe my interpretation had overlooked some important aspects.



This is a first part of the series on Islamic finance.

Normal commercial insurance is not Islamic because
a. It is perceived as gambling or a game of chance. The insurance company issues the policy with the hope that it will make money and if the stated even occurs loses money.
b. It invests its surplus money in interest bearing instruments

Because of these reasons the Islamic world had come up with 2 very good insurance instruments.

• Mudharabah Model
• Wakalah Model

The essence of these models is that all the investors pool their money together and promise to pledge each other in case of death or financial distress. In a good year the corpus will have more money than it needs and hence would return them back to the policy holders. Hence creating a cooperative society which shares its risks by hedging them.

This is how the insurance started. A group of workers (esp. lumberjacks) setting aside a small sum to pay for the medical expenses in case of an accident at worksite. Most insurance companies issue policies worth many times more than their net worth. If the various models used by securitization experts can fail, so can the mortality predictions of the actuaries in insurance agencies. Monoline Insurance companies have failed; nobody knows the real net worth of the financial institutions. Hence it’s time for the insurance companies to return to the basics.

I could find a few Malaysian and Middle eastern firms issuing such policies for businesses, however I am yet to find a personal insurance policy in India following these principles. Its probably because of IRDA rules.