Getting to Know Islamic Banking

♠ Posted by Emmanuel in , at 2/27/2008 05:18:00 AM
I am fascinated by this race among financial centers and major banks to create Islamic banking products [1, 2]. With the oil windfall set this year to hit an amount unimaginable to your humble correspondent who takes public transportation and cuts out store coupons, Islamic banking has become all the rage. As you know, Shar'ia law prohibits the charging of interest. However, many observers and I myself have observed that these Islamic banking instruments basically emulate the concept of interest without actually calling it so. Is there anything fundamentally different to it, or am I correct?

In any event, one of the banner ads in the Financial Times brought me to this HSBC site hawking Islamic banking products. Here's a sample; figure out for yourselves what the difference is from regular banking. As I've said, it's beyond me...

Mudaraba [="venture capital"?]
A mudaraba transaction is an investment partnership. In a mudarab arrangement, the contract is between an investor (or financier) and an entrepreneur or investment manager known as the mudarib. Risk and rewards are shared. In the case of a profit, both parties receive their agreed-upon share of the profit. In the case of a loss, the investor bears any loss of capital while the mudarib loses his time and effort.

Transaction Process
A generic mudaraba process could take the following basic form:

  • Step 1: The investor and the mudarib agree on the nature of the venture and the terms of profit sharing.
  • Step 2: The investor provides capital to the mudarib.
  • Step 3: The mudarib undertakes the venture agreed upon between the parties
  • Step 4: Profits from the investment are shared between the investor and the mudarib

Ijara [="lease"?]
An ijara is an Islamic lease. The bank purchases an asset and leases it to a client for fixed monthly payments. An ijarah may include an option for the lessee to buy the asset at the end of the lease, though such a provision is not required.

Transaction Process
A generic ijarah process could take the following basic form:

  • Step 1: The bank and the client agree on the terms of the lease.
  • Step 2: The bank purchases the asset from the seller.
  • Step 3: The client leases the asset from the bank, paying a fixed monthly rental
  • Step 4: The client purchases the asset from the bank at the end of the lease period.

Murabaha [="installment purchase"?]
A murabahah transaction is a sale at a stated profit. In a murabahah transaction, the bank purchases something from a third party and sells it to the client at a stated profit on a deferred payment basis. In this way, the client can buy something without taking an interest-based loan.

Transaction Process
A generic murabahah process could take the following basic form:

  • Step 1: The client expresses intent to engage in a murabahah transaction facilitated by the bank and, subject to bank approval, signs a "Promise to Buy".
  • Step 2: The bank purchases the item from the seller.
  • Step 3: The client purchases the item, in instalments, at the purchase price plus a stated profit.