Financial Products: Islamic vs. Modern

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Financial markets (such as bond and stock markets) and the financial intermediaries (such as banks, insurance companies, and pension funds) are two essential components in the financial system that exists to ensure the system works properly and appropriately. These components operate by connecting people to transact by such manner where they can satisfy the needs and wants. Similarly to the Islamic financial system, the same components are needed to develop the good economic health but in the Islamic financial system, there is prohibition of receipt and payment of interest in the nucleus of the system. However it is supported by other principles of Islamic doctrine advocating risk sharing, individuals' rights and duties, property rights, and the sanctity of contracts.

The basic framework for an Islamic financial system is a set of rules and laws, collectively referred to as Shariah, governing economic, social, political, and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the sources of Islamic law. The sources refer are in sequence as follows: (1) the Qur'an, (2) the hadith texts (the words, actions, recorded statements and practices of Prophet Muhammad (pbuh) and this include hadith Qudsi), (3) Ijma (consensus of the ulama) and qiyas (drawing analogies deduction and reasoning from the Qur'an and hadith texts), and (4) Ijtihad (the scholar's own reasoning). Note that a scholar's ijtihad only comes after the analysis of the other sources, and remains within the parameters established by them.

Therefore, the basic principles of an Islamic financial system can be summarized as follows:

4:161. “ And their taking of Ribâ (usury) though they were forbidden from taking it and their devouring of men's substance wrongfully (bribery, etc.). And We have prepared for the disbelievers among them a painful torment.”

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, symbolize successful business and creation of additional wealth whereas interest, determined gambling, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

2:219. “ They ask you (O Muhammad) concerning alcoholic drink and gambling. Say: "In them is a great sin and (some) benefit for men, but the sin of them is greater than their benefit." And they ask you what they ought to spend. Say: "That which is beyond your needs." Thus Allâh makes clear to you His Laws in order that you may give thought."”

Whether the conventional or Islamic financial system, both are not limited to banking but also covers capital formation, capital markets, and all types of financial intermediation. These financial intermediations offer lots of financial products to be traded in the financial markets as the intermediaries to improve the economic well-being. In the Islamic financial system, risk sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts are being encouraged, and it closes the door to the concept of interest and precludes the use of debt-based instruments.

The financial products offer in the financial system by the banking institution includes financing facilities for asset acquisition, trade financing and corporate financing. These different contacts i.e. Mark-up Sale (Murabahah), Sale with Deferred Payment (Bai Bithaman Ajil), Leasing (Ijarah), and Benevolent Loan (Qardhul Hasan) are some of the products offer under the financing for assets acquisition. Meanwhile letter of credit, letter of guarantee, accepted bills, and working capital financing are offered for financing purposes (trade and corporate). Different instruments are offered by the market to satisfy providers and users of funds in a variety of ways. These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets.

Therefore, in some aspects, the Islamic banking and conventional banking have something in similarities. Islamic banking and conventional banking are similar in the structure of the organization and the using of the financial statement. Both Islamic banking and conventional banking offer different instruments and products in order to satisfy their customers and users of funds in a variety of ways. This includes sales, trade financing and investment. Furthermore, both of them are the same in receiving money transaction, in doing proposal and guidelines in giving out funding or finance.

The later part of this paper discussing certain financial products offer in the financial market by making comparison between conventional financial product and Islamic financial product to see its similarities and differences. Those financial products are leasing (Ijarah), Letter of Credit and Islamic Private Debt Securities (IPDS).

LEASING Vs IJARAH

Leasing can be defined as a contract allowing the use of a particular asset for a specified time. Leasing can takes in three different forms: (1) sale-and-leaseback arrangements, (2) operating lease, and (3) straight financial, or capital leases. Leasing is as alternative to obtaining the use of asset without owning it by buy it. By having the lease the business easy to acquire new capital equipment to finance it business operation.

Under a sale and leaseback, a firm that owns land, buildings, or equipment sells the property and simultaneously executes an agreement to lease the property back for specified period under specific terms. The purchase could be an insurance company, a commercial bank a specialized leasing company, or even individual investor. This sale and leaseback plan is an alternative to taking out a mortgage loan.

The firm that selling the property or called as lessee will immediately receive the purchase price put up by the buyer or called as lessor. At the same time, the seller-lessee firm retains the use of the property just as if it had borrowed and mortgaged the property to secure the loan. Under sale-and-buyback arrangements, the lease payments are set up as to return to purchase price to the investor-base while providing a specified rate of return on the lessor’s outstanding investment.

Operating leases or called as service leases provide for both the financing and maintenance. Under this type of lease, the lessor responsible to maintain and service the lease equipment, and cost of providing maintenance is built into the lease payments. Another characteristic of the operating lease is that it frequently does not fully amortized, which mean the payments under this operating lease are not sufficient enough to recover the full cost of the lease assets. Another feature of the operating leases is they frequently contain a cancellation clause, which gives the lessee the right to cancel the lease before the expiration of the basic agreements.

Financial leases or called as capital leases basically similar to the operating leases except they differ in these three areas: (1) they do not provide the maintenance service, (2) they are not cancelable, and (3) they are fully amortized (payments equal to full price of lease assets). Principally, financial leases similar to the sale-and-leaseback arrangements but the major difference is that under financial lease, the lease asset is new and lessor buys it from a manufacturer or distributor instead of from the user-lessee.

Similar to Islamic financial market, leasing is one of the most popular products in it (accounting for about 10% of Islamic financial transaction). Leasing is not originally modes of finance but this contract is approved and allowed by Syari’ah to meet certain specific needs (subjects to certain conditions), which the other instruments likes Musharakah and Mudharabah are not workable for it.

‘Ijarah’ is a term of Islamic fiqh which derived from an Arabic terms which means “to give something on rent”. In this case, the term ‘Ijarah’ is equivalent to the English term 'leasing'.In Islamic jurisprudence, the term ‘Ijarah’ is used for two different situations. Firstly, it means to employ the services of a person on wages given to him as a consideration for his hired services and secondly related to the usufructs of assets and properties, and not to the services of human beings.

'Ijarah' in this situation means "to transfer the usufruct of a particular property to another person in exchange for rent. It’s a contract where the financier buys and leases equipment or other assets to the business owner for a fee or more often called rental income. However, the first type of Ijarah is not really related with Islamic finance because it’s not generally used as a form of investment.

Based on the explanation and definition above, contains the important terms of Ijarah (as a basic rules) under Syari’ah, there are:

Lessor and lessee also must know and aware the following conditions, which make Ijarah to be acceptable as the Islamic financial product, those are:

LETTER OF CREDIT

A letter of credit is one of the banking products, which allows importers to offer secure terms to exporters. It has been used for many years in international trading transactions. The issuing bank's role is to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due.

"A letter of credit is a payment undertaking given by the issuing bank on behalf of the buyer/applicant to pay a seller/beneficiary a given amount of money on presentation of specified documents representing the supply of goods within specific time limits. These documents must conform to terms and conditions set out in the letter of credit and documents must be presented at a specified place."

There are numerous of advantages for both the seller or the exporter and the buyer or importer when they are using the letter of credit. By using the letter of credit, seller is secured because the letter of credit offers security to the seller as an assurance of payment from an international bank. Besides, the seller can raise finance when a letter of credit has been issued in his favor.

Meanwhile for buyers, they do not have to pay cash up front to a foreign country before receiving the documents of title to the goods purchased. So it will be helpful for the buyer when he confronted with unfamiliar of local suppliers and legalities. The letter of credit also protects the buyer's interests as the bank will only pay the respected supplier on behalf if they present needed or required documents that have been asked for. Payment will be given if these documents comply with the terms and conditions set out in the letter of credit. By using the letter of credit the buyer can build safeguards such as inspection of the goods, quality control and set production and delivery times.

Murabahah is the concept used for the letter of credit under the Islamic financial system. Murabahah is often referred to as ‘cost-plus financing’ and frequently appears as a form of trade finance based upon letters of credit.

Where it is practiced in the modern financial market, Murabahah usually obeys the following terms:

PRIVATE DEBT SECURITIES Vs

ISLAMIC PRIVATE DEBT SECURITIES

Islamic Private Debt Securities (IPDS) is one of the products offered in the Financial Market (Capital market) and it is among the important securities that have been playing its role efficiently. IPDS has come out from a chain of transactions that create the essence from the underlying debt, which is the subject matter of the process.

In the conventional mode the debt usually generates interest, which is recognized as the riba in Islamic terms. Riba (usury) is any income generated through interest payment via lending or credit activities.

Therefore, when IPDS were first created, there is a condition exists; that before a debt can be sold or negotiated, there must be an underlying contract of sale and purchase. These contracts should involving real tangible assets at the beginning of the process. The transaction cannot be just the creation from nothing. The sale and purchase contract normally contains a delayed payment element in it so that a debt is created.

Then, this debt will become the intended securitization. It is just like the concept of bai’ al-inah. Bai’ al-inah allows sale and buy-back transactions so that an earlier sale of assets would produce a cheaper price compared to the price for the subsequent sale.

The whole process of IPDS involves several inter-related transactions. Firstly is the normal sale and purchase contract ( al-bai’). For instance, customer A sold his assets to the financier in the first transaction the sale price was RM100 million. Secondly is the buy-back transaction. This transaction occurred immediately after the first transaction where the buy-back price is at cost of RM210 million. These two contracts; the buy-back and normal sale are known as Bai’ al-inah. Thirdly, the payment for the buy-back transaction is delayed through the installment mechanism known in Islam as Bai’ B ithaman Ajil (BBA) or deferred payment.

Subsequently, the debt as owed by the customer A resulting from the buy-back transaction will then be sold as securities accompanied by a certificate or note. Lastly, when this debt is sold as securities another concept is used or being applied, i.e. bai’ al-dayn or sale of debt. All the steps above have clarifies and portrays the differences between a conventional (bond) and an Islamic bond (security).

In the conventional sense, a bond is a debt instrument whereby the issuer will pay a certain percentage of interest to the buyer of the issued bond, or if it is a zero coupon bond, it will be issued at discount and repaid in full at maturity. Bondholders will receive the proceeds in the form of interest. In contrast, the debt created in the IPDS transaction is an unpaid purchase price owed by the customer to the financer. Such a debt is not a result of a money-lending (Islamic term: al-Qard) process as there was no such activity.

Therefore from the explanation above, IPDS may be structured along Al-Bai’ Bithaman Ajil, Al-Murabahah and Al-Bai’ Al-Dayn. Al-Bai’ Bithaman Ajil or deffered payment sale refers to the sale of goods on the differed payment basis. The financial institutions, bank for example buys assets that are requested by the customer and subsequently sells the goods to the customer at an agreed price (the sale price), which includes the bank’s mark up (profit).

Al-Murabahah or cost-plus financing as explained in the Islamic Repo section refers to the sale of goods at price, which includes a cost-plus profit margin as agreed by both parties. Such sales contract is valid on the condition that the price, other costs and profit margin of the seller are stated at the time of the agreement sale.

Lastly is the Al-Bai’ Al-Dayn which is refers to the debt financing that is the provision of financial resources required for the production, commerce and services by the way of sale or purchase of trade documents and papers. Only documents evidencing real debts arising from bona fide merchant transactions can be traded.

CONCLUSION

Financial products offered by the Islamic banks, just like the conventional banks, aims to gain profit. However in the Islamic financial system, the intermediaries are not allowed to deal with interest or to engage in any business or trade prohibited by Islam. Islamic financial industry is finance and banking activity that is based on Shari’ah principle. It always promotes profit sharing in the conduct of finance and banking businesses for the sake of its participants.

Islamic practices has the same purpose as the conventional practices except that the Islamic practices, it operates in accordance with the rules of Shari’a known as Fiqh al-Muamalt (Islamic rules on transaction). This is where the common Islamic concepts such as Mudharabah (profit sharing), Wadiah (safekeeping), Musyarakah (joint venture), Murabahah (cost plus), and Ijarah (leasing) are used wisely in its transaction.

The most important difference between Islamic and conventional practices is in the Islamic financial activity the trading principle of buying and selling must be on the fair basis and the profit is legitimate and the monopoly and hoarding is prohibit in all means. Usually in the Islamic financial system, it based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning that can cause harmful to society or each other.

Whatsoever reason given, the Islamic financial system, the Muslim themselves strive harder to seek the pleasure of Allah. Therefore, the activities they done always give the benefit not only to him but also for the sake of others. The pleased activities will harmonize the system itself not only the economic nor financial but also including the social and morality.