Preface

Contracts and Deals in Islamic Finance is a unique idea for which I have my professors and industry peers to thank. It is a collaborative effort between two conventional bankers with Islamic roots and aims at addressing some basic fundamentals of Islamic finance and banking and explores complex enhancements to traditional contracts that are the pillars of Islamic banking.

This work we hope will be of use not only to students, beginners, and practitioners, but banks, central banks and governments that are trying to get a grip on this subject.

This work has been designed keeping in mind the cynic and the skeptic who feels that Islamic finance is a mere twisting of legal terms to achieve ends that replicate loans. To such a cynic we can only ask him or her to read the book. The coauthor of this book, who approached the subject of Islamic finance with equal skepticism, however, at one point had to question his own assumptions and expectations.

One key aspect that is explored is what do we as Muslims expect from Islamic financial institutions (IFIs)? If we expect IFIs to finance us with money and then forgive the resulting debt obligations later on, then this is an unrealistic expectation, as we see later that IFIs are not financing borrowers using their own money, but that of their depositors. If we expect IFIs to offer loans on "generous" terms, on terms that make losses for the IFI, then this is also incorrect as Islam allows a Muslim a right to profit making within certain conditions. If we expect IFIs to finance us money and only ask to be repaid when and if we as borrowers generate profits from investing the mobilized funds, then this expectation can be accepted but provided the debtor fulfills certain covenants of contracts and acts with a sense of responsibility as well.

Is it the purpose of Islamic finance to reduce poverty, or to extend money to poor people? This expectation can be addressed, but fundamentally, this depends on the type of IFI concerned. If the IFI is engaged in microfinance, then the answer would be yes, but if the IFI exists for commercial reasons, in that it exists to make a profit, then an IFI can no more be expected to give loans to the poor with high risk of default than a shoemaker can be expected to sell shoes at cost price to the poor.

In essence, IFIs exist not to make benevolent loans, to give charity, or to eradicate poverty, but to generate profits for shareholders and capital providers from providing financingproviders from providing financing through shariah-compliant financial products.

IFIs are as entitled to profit as any other commercial enterprise within the halaal industry. They are a component of a halaal economy and play the role of financial intermediaries.

The world of finance is rather different than the world of service providers, trading, or manufacturing. In the world of manufacturing, inventors evolve into entrepreneurs and raise funds through different means, either from banks or by selling shares in their businesses. The created entity, the firm, however, uses its own funds to manufacture goods and then sells them at a profit. Traders purchase goods from one market at a cost price and sell them in another market at a profit, at times in different countries and in different currencies. Service providers also use their capital to set up certain infrastructures to enable them to operate and then charge customers a price for the services they render.

Financial institutions are unique in that they are set up by shareholders who combine their capital to set up a retail bank, a commercial bank, an investment bank, an asset management company, a brokerage firm, a mutual fund, a finance company, or an insurance company. But shareholders do not lend their money to borrowers in the case of the banking model.

Shareholders provide capital to set up a conventional bank and then mobilize deposits from households, businesses, corporations, governments, and international investors, and lend these monies to households, businesses, corporations, governments, and international borrowers. Banks, if they mean to refer to shareholders, do not lend their own money; they leverage on their own capital to borrow from surplus economic units and lend to deficit economic units, making a spread between the income earned from financing activities and the expensed paid as cost of mobilizing deposits. Islamic banks do no different, but perform these same functions using shariah-compliant contracts for mobilizing profits, extending financing, recording profits, and sharing profits and expenses.

The principles of the shariah govern how these activities are conducted, but the core activity of an Islamic bank and a conventional bank are the same. Depositors in essence give their consent to bankers to extend financing with their moneys out to qualified borrowers provided that the customer has no exposure to the risk of losing capital or expected profit from the borrower's default. If we were to look at the concept of risk sharing, this would not be much different from conventional depositors and requiring guarantee on their principle amounts. More on that later. Islamic bankers like conventional bankers must have the expertise in identifying suitable candidates for financing, and must have the expertise in mitigating all the risks involved in credit finance and other aspects of managing money.

Asset management firms raise funds from investors and invest these funds in financial assets for a return. Asset managers have the expertise in raising funds and in knowing how to invest them in different market circumstances to get a positive return on investments. Fund managers perform this function either on a principal and agency basis, or on commission basis. Islamic fund managers do the exact same thing except they must mobilize funds from halaal sources and invest them in shariah-compliant assets. Scholars have established various criteria for determining whether a certain asset is shariah-compliant.

Investment bankers and Islamic investment bankers fulfill the same roles in an economy. Islamic investment bankers may have fewer assets at their disposal due to the restrictions on investments in derivatives. However, Islamic investment bankers help companies raise money through initial public offerings, underwrite issuances of sukuk, raise funds from investors, sell financial products, and make investments in various assets to earn returns. Islamic investment bankers, however, must perform all these functions according to contracts and processes permitted by shariah.

Similar to insurance companies that underwrite risk, takaful companies underwrite risks as well. Insurance companies factor their cost of insuring risks into the premiums they charge by a simple formula, "probability of event occurring × sum assured." Takaful companies underwrite risks in a similar fashion but use different contracts of tabarru and wakala to perform the same function.

Islamic brokerage firms must adapt to trading practices that are shariah-compliant, but in every other way are similar in their roles to conventional brokers.

Islamic banks use the same methodologies of financial mathematics, econometrics, and financial modeling to develop models of risks and returns as conventional banks and also use a benchmark interest rate to discount future cash flows to a present value. These elements are part and parcel of the Islamic financial system. Islamic financial institutions use the same T-accounts methods of accounting that we are all familiar with. Assets, liabilities, equity, debt, income, expenses, and so on, are all parts of an IFI's balance sheets. However, how different economic events are recorded to be shariah-compliant can be unique in many cases.

Islamic banks recognize entries such as "unearned income," "constructive liquidation," future income, and so on, much in the same fashion as conventional banks.

One may, therefore, rightfully ask, "What is the difference between Islamic banking and conventional banking?" An initial response would be that the vision to date behind Islamic banking has been to provide conventional financial products in a shariah-compliant manner. So there has been no incentive so far to be different; the incentive has to only be shariah-compliant.

Is there a difference between a wedding contract in a Christian church and a wedding contract in a mosque? One may well argue that both contracts contain positive and negative covenants that assign rights to each party of the contract and impose simultaneous limitations on each party to the contract. On the surface, both contracts of a Christian marriage and a Muslim marriage may well be similar, but Islam allows certain things that Christianity may not allow and Islam may forbid certain rights to either party that the Christian worldview may allow. Both contracts would require two parties having the legal capacity to contract, an offer, an acceptance, certain terms and conditions imposed by one party over the other, and some terms and conditions imposed by the worldview of the religions in question. The differences would be minor but yet are differences nevertheless. This is the kind of subtlety of differences that lies in the discussion of some of the broader issues in Islamic finance, such as risk sharing and equity.

Our approach to the subject must be built carefully, without emotion, without preconceived assumptions (no bank is sponsoring the authorship of this book), and with an open mind. If...